Australian Competition and Consumer Commission. Insurance Industry Market Pricing Review

Transcription

1 Australian Competition and Consumer Commission Insurance Industry Market Pricing Review March 2002

2 Australian Competition and Consumer Commission 2 Table of Contents Executive Summary 1 Introduction Limitations Qualifications 2 2 Insurance Overview Industry Background Major Market Influences Mergers and Acquisitions Industry Growth Industry Performance Financial Performance 20 3 Catastrophes and Reinsurance World-Wide Catastrophes Catastrophe Events in Australia Conclusion on Catastrophes Purposes for Which Reinsurance Is Used The Extent of Reinsurance by Class Of Business Profitability of Reinsurance in Australia Reinsurance Conclusion 36 4 Industry Profitability Insurance Cycle Classes in Perspective Profitability of Individual Classes Summary 55 5 Pricing Corporate Objectives Legislative environment Reinsurance/Capital Competition Approach to Pricing Cost Drivers of Classes of Business 70 6 Summary of Insurer Responses AAMI Allianz AMP CGU Fortis NRMA QBE Mercantile Mutual RACT Royal & Sun Alliance Suncorp-Metway Zurich Munich and Swiss Re 81

3 Australian Competition and Consumer Commission 3 7 Summary of Results Impact of State Taxation Insurer Responses 82 8 Impact of the Liquidation of the HIH Group Background Movement Prior to Liquidation HIH Market Share Insurer Responses General Impact of the HIH Group Liquidation on the Market Impact of Increased Insurance Premiums Introduction Is General Insurance Understood by Consumers? What the industry tells consumers about price Recommendations Regarding Pricing Information An Information Asymmetry General Insurance Policies Terminology and Conditions Recommendations on Terminology and Conditions 116 Glossary of Terms Bibliography Appendices A Description of Regulatory Bodies B Components of Profit C Insurance Industry Statistics and Analysis D The Commission s Request to Insurers

4 Australian Competition and Consumer Commission i Executive Summary This synopsis highlights the main findings of the investigation into premium increases in the general insurance industry, full details of which are contained in the attached report. The report was prepared by the Australian Competition and Consumer Commission (the Commission) at the direction of the Hon. Joe Hockey MP, the Minister for Financial Services & Regulation at time of the request, to report on changes in the insurance market and specifically on the upward movement of insurance premiums. It was prepared with the assistance of Taylor Fry Consulting Actuaries. Purpose The purpose of this report is: A. To examine the current state of the insurance market specifically with respect to: the influence of the international insurance market; the major lines of HIH s business and any links to the profitability of those lines; cost drivers for each class of business; and profitability of the industry class by class and overall. B. Examine reasons for premium increases forwarded by insurers in response to the Commission s request for information. C. Address issues brought to the Commission s attention by the general public. Currently the Commission does not have general powers of price monitoring or control 1, nor does it have preconceptions of what prices might be too high or too low for insurance or products generally. Prices for products outside the regulated utilities generally are of concern mainly in relation to circumstances where they may indicate restrictive practices (the exercise of market power) for example price fixing, resale price maintenance or predatory pricing. The Commission would be concerned if large increases in premiums beyond general inflation were instituted with reference to the collapse of HIH or the events of 11 September 2001, when there were in fact no cost implications to insurers from such situations. Such opportunistic pricing could not be sustained in a competitive market. As noted above, its concern would focus on circumstances where price movements may indicate the exercise of market power. 1 The Prices Surveillance Act 1983 enables the Commission, where the Government declares products or services, to formally monitor prices with the objectives of promoting competitive pricing wherever possible and restraining price rises in markets where competition is less than effective.

5 Australian Competition and Consumer Commission ii Industry Analysis The insurance industry has experienced low returns on equity over the last nine years. The average return has been little higher than could have been obtained by investing in cash although shareholders have borne a significant risk. The extent of the risk is highlighted by the liquidation of HIH Group where shareholders are expected to lose their total investment. Most classes over the last decade (or in more recent times) have contributed to that Low return. Seven of the fifteen APRA classes (most notably Fire and Industrial Special Risks (ISR), Professional Indemnity, Product & Public Liability, Travel and Other) have had Very Low or Low return on capital. If insurers respond by increasing premiums, these classes are likely to be under the most pressure to do so. Results of an examination of the return on capital on a class by class basis is contained in Table 1. Table 1 Performance and Outlook Class of Business Overall Recent Outlook Fire and Industrial Special Risks Moderate Low Low Houseowners/Householders Moderate High High CTP Motor Vehicle Low High Moderate Commercial Motor Vehicle Moderate High High Domestic Motor Vehicle Low Low Moderate/High Marine and Aviation Very High High High Professional Indemnity Low Very Low Very Low Product and Public Liability Low Very Low Very Low Employers' Liability Low Low Low Mortgage Very High Very High Very High Consumer Credit Very High Very High Very High Travel Low Very Low Very Low Other Accident High High Moderate Other High Very Low Low Inward Treaty High Low Unclear Overall Moderate Low Low Descriptions of Low, Very Low, Moderate, High and Very High are contained in the report Consistent with that analysis, insurers reported the largest premium increases during the last year have been for ISR, Professional Indemnity and Product & Public Liability. In addition, a wide range of increases was reported for Public & Product Liability and Domestic Motor Vehicle.

6 Australian Competition and Consumer Commission iii The increases suggested by the reported averages for ISR, Professional Indemnity and Public & Product Liability are supported by the alignment of several underlying drivers. The key driver for recent premium increases has been the shift by insurers from establishing targets for business growth as measured by premium volume to setting targets for return on equity and the realisation that recent Low returns on capital for many classes has occurred through a combination of: Inadequate premium rates (Domestic Motor, ISR, Professional indemnity, Public & Product Liability and Travel) Catastrophes such as Sydney hail storm and South East Queensland flood affecting the profitability of the retained business (Fire & ISR, Domestic and Commercial Motor, Householders/Homeowners) Realisation of the extent of past losses as liability provisions are increased to reflect emerging claims experience (Professional Indemnity and Product & Public Liability) Low investment returns which represent a significant and important component of insurance profit (Liability classes) Increasing reinsurance premiums resulting from continuing Low profitability of the international reinsurance market. While largely uninfluenced by domestic catastrophes increased reinsurance rates have occurred at a similar time as domestic catastrophes (Fire & ISR and Householders/Homeowners) Liquidation of the HIH Group potentially removing a barrier to price increases (Professional Indemnity) Recent premium increases and re-rating of portfolios appears to have restored the profitability of Domestic and Commercial Motor. Therefore, it would be difficult for the industry to justify further increases. The Low returns achieved on the Domestic Motor and Employers Liability classes are a testament to the competitive market for such business. These competitive pressures are expected to restrain further premium increases in these classes. While many of the classes have exhibited Low returns on capital, insurers have also enjoyed High/Very High returns for Marine and Aviation, Consumer Credit, Mortgage, Commercial Motor and more recently CTP Motor. It must be remembered that many consumers will receive substantially higher increases (and also lower) than the simple averages shown in the report. Significantly higher or lower increases may arise from either re-rating of the portfolio by the insurer, change of circumstance (eg loss of no claim discount, change of motor vehicle, change of address, etc) or change of insurer. Consumers forced to change insurers following the liquidation of the HIH Group are likely to experience the highest increases.

7 Australian Competition and Consumer Commission iv Recommendations The Commission makes several recommendations to the general insurance industry intended to assist consumers assess whether premiums being offered are acceptable. A. Increases to the previous policy s premium should be clearly explained when policies are offered for renewal. This could be achieved by a note summarising what premium was paid last year, whether coverage is extended or proscribed and what other factors, such as risk rating factors, have been reassessed so as to cause a change in premium; B. The industry should provide consumers at large with general premium trend data for the various classes of insurance, and comprehensible explanations outlining the influence of the major cost drivers on premiums. The absence of publicly available premium information does not promote consumers general level of awareness or confidence in the general insurance industry; and C. Insurers should improve their premium complaints and query handling systems to enable consumers to contest premium assessments and access detailed explanations for specific increases. The Commission also makes several suggestions for consideration by the general insurance industry. A. Insurance contracts in each class and policy area sought by consumers, small business and community organisations should contain on the front page of policies a standard checklist that would use generic terms for each type of insurance cover. B. Increase where practicable the use of standard terms across policies. C. Utilise large font, direct and plain English disclosure (supported by consumer testing of policy documents by companies) of the extent of any exclusions, with practical examples to highlight impacts (eg if your house catches fire in X situation, or you are robbed by Y, we will seek not to cover your claim etc). Just as the Commission supports any attempts to promote transparency in the flow of information between insurer and insured, the Commission also believes that insureds should be provided with information in a timely manner. Although the notion of good faith is extremely broad, the Commission believes that it should include the assumption that insurance companies do not allow there to be any unreasonable delays in providing an insured with explanations.

8 Australian Competition and Consumer Commission 1 1 Introduction On 7 June 2001, the Australian Competition and Consumer Commission (the Commission) was requested by the Hon. Joe Hockey MP, the then Minister for Financial Services & Regulation to report on recent changes in the insurance market and specifically on the upward movement of insurance premiums. At the time of the request the failure of the HIH Group of companies was expected to have a significant impact on the general insurance industry given that HIH was the second largest insurer in Australia. In response to this request, the Commission, with the assistance of Taylor Fry Consulting Actuaries, reviewed the general insurance market and approached a number of general insurers for information on changes to pricing regimes and the reasons for these changes. The information requested from general insurers and the analysis undertaken of the institutions responses was conducted to achieve a broad review of the market and pricing levels and as such this review does not concentrate on particular insurers or particular policies. The insurers that the Commission approached for information were selected on the basis they represented approximately seventyfive per cent of the Australian general insurance market. During the course of the review process the Commission received numerous complaints and queries from the public concerning premiums. The report also addresses these issues. Part A of this review examines the current state of the insurance market specifically with respect to: the influence of the international insurance market; the major lines of HIH s business and any links to the profitability of those lines; cost drivers for each class of business; and profitability of the industry class by class and overall. Part B is a review of the returns provided by insurers following a request to furnish information by the Commission. This review includes a summary of premium rate increases and comments made by insurers. Part C of this review addresses issues brought to the Commission s attention by the general public.

9 Australian Competition and Consumer Commission 2 Currently the Commission does not have general powers of price monitoring or control 2, nor does it have preconceptions of what prices might be too high or too low for insurance or products generally. Prices for products outside the regulated utilities generally are of concern mainly in relation to circumstances where they may indicate restrictive practices (the exercise of market power) for example price fixing, resale price maintenance or predatory pricing. The Commission would be concerned if large increases in premiums beyond general inflation were instituted with reference to the collapse of HIH or the events of 11 September 2001, when there were in fact no cost implications to insurers from such situations. Such opportunistic pricing could not be sustained in a competitive market. As noted above, its concern would focus on circumstances where price movements may indicate the exercise of market power. 1.1 Limitations This report has been prepared with information available to hand, typically up to 30 June Where possible updated information was used. Other material or analyses may be available that was not considered, which could lead to a different interpretation than expressed in this report. The analysis is based on information provided from a range of sources, including, but not limited to, the Australian Prudential Regulatory Authority (APRA), its predecessor the Insurance and Superannuation Commission (ISC), sigma (a publication of Swiss Re) and publications of Ord Minett and JP Morgan Securities. All sources are identified in the report. In particular, Taylor Fry has relied on statistics published by APRA in analysing the profitability of the insurance industry. The results and conclusions drawn from the analysis could be flawed if the information supplied by APRA (or to APRA by the insurers) is incorrect or incomplete. 1.2 Qualifications Companies do not operate in a uniform manner: each company has its own profit targets, capital structure, distribution channels, policy terms and conditions, target markets and objectives. Apart from the fact that information is provided by companies at differing balance dates, aggregation of statistics can be misleading simply due to differing interpretations of the governing legislation and regulations. The analysis and commentary is based on analyses of these aggregated statistics. However, other interpretations may have been possible if knowledge of specific company circumstances were available. 2 The Prices Surveillance Act 1983 enables the Commission, where the Government declares products or services, to formally monitor prices with the objectives of promoting competitive pricing wherever possible and restraining price rises in markets where competition is less than effective.

10 Australian Competition and Consumer Commission 3 PART A Profitability of the Insurance Industry

11 Australian Competition and Consumer Commission 4 2 Insurance Overview This section of the report provides a brief overview of the industry, developments and major influences that have affected the industry in recent years. 2.1 Industry Background Statistics used in this report have been derived from published APRA (available from 1996/97) and ISC (available from 1992/93) statistics. The analysis primarily relates to the period from 1992/93 to 2000/01. Other sources are referenced for periods prior to 1992/93 where required. APRA statistics relate only to the Private Sector while some Public Sector insurers report information to APRA, the published statistics relate only to the Private Sector insurers. The following provides a brief summary of the market Numbers of Insurers The number of Private Sector companies authorised to conduct general insurance business increased by 5 to 156 in the year ended 30 June 2001 (151 in the year to 30 June 2000). This increase reverses the downward trend that had been apparent up to 30 June 2000 and suggests the rationalisation of the insurance market observed in recent years has either temporarily stalled or even ceased. Table 2.1 Number of Insurers by Type Type of Insurer 31-Dec Dec Jun Jun Jun-01 Direct Underwriter Mortgage Insurer Captive Reinsurer s.37 Exempt insurers Victorian Workcover 12 Total Private Sector Total Public Sector Selected Statistics on the General Insurance Industry APRA June 2001 The Insurance Act (1974) governs these companies. In addition, there are Public Sector insurers who are not subject to this Act but write general insurance business such as: workers compensation schemes at the federal level (Comcare) and in Victoria, New South Wales, South Australia and Queensland; transport accident schemes in Victoria, Tasmania and South Australia; and

12 Australian Competition and Consumer Commission 5 specialist insurers Victorian Managed Insurance Authority, Joint Coal Board, Export Finance and Insurance Corporation, etc. Ninety seven percent of the $7 billion in premium revenue reported to APRA for 200/01 relates to the accident compensation schemes ($5.3 billion Employers Liability and $1.5 billion CTP Motor Vehicle). These specialist insurers are not included in the scope of this review Major Participants Although APRA recorded 156 Private Sector insurers at 30 June 2001, the industry is dominated by less than 10. Table 2.2 lists the top 20 conglomerates (based on APRA s June 2001 report) by premium revenue and shows they wrote 83 percent of all business. The top 10 wrote 71 percent of premium revenue. Table 2.2 Major Private Sector Insurers Group Name Premium Revenue $'000 Insurance Australia Group Limited 3,563,011 Royal & Sun Alliance Insurance Australia 2,104,942 Suncorp General Insurance Ltd 1,894,281 CGU Insurance Limited 1,580,122 Allianz Australia Limited 814,484 Ing/Mercantile Mutual 579,901 QBE Insurance Limited 567,205 Zurich Australian Insurance Limited 563,613 Swiss Reinsurance Company 554,814 Munich Reinsurance Company 503,002 AMP General Insurance Limited 428,018 General & Cologne Reinsurance Australasia Ltd 286,296 Gerling Australia Insurance Limited 279,572 Lumley General Insurance Limited 277,839 AIG Group 250,285 Hannover Re 206,298 Wesfarmers Federation Insurance Limited 172,279 GE Capital Group 146,736 Commonwealth Insurance 118,218 Westpac 93,742 Top 20 14,984,658 Industry Total - Private Sector 17,972,331 Source: APRA Selected Statistics on the General insurance Industry Year Ended 30 June 2001 Tables 1a and 14b To illustrate the dynamic nature of the insurance industry, in the 12 months since APRA s June 2000 report was prepared: Allianz has moved to 100 percent ownership of MMI; the HIH Group has gone into liquidation;

13 Australian Competition and Consumer Commission 6 Allianz has 100 percent of a joint venture originally with HIH called Allianz Australia Alliance (AAA) which covers personal lines and some small commercial lines; NRMA acquired HIH s Workers Compensation portfolio; AMP General Insurance merged with GIO, which was subsequently transferred to Suncorp-Metway; Suncorp-Metway acquired RAA-GIO Insurance and RACQ Insurance; and CGU purchased Fortis Australia Capital Requirements APRA introduced new capital requirements for general insurance companies that take effect from 1 July The effect of these changes is to increase the minimum level of capital supporting insurers with the objective of reducing the likelihood of insurers failing. Typically, investors in insurance companies will seek a return on their equity that is commensurate with the risk. Additional capital raised to meet the new requirements will need to be serviced as investors are unlikely to subscribe more capital without an expectation of achieving a reasonable return Implication of Capital Requirements In order to achieve the necessary returns on a higher capital base, insurers can be expected to increase profit either by: i) achieving greater operating efficiencies (possibly through mergers) ii) iii) increase investment returns (possibly by assuming greater investment risk) increasing premiums Alternatively, if they increase capital, but do not increase profit by any of the options detailed above, then the return on capital will decrease. 2.2 Major Market Influences Over the past decade the insurance industry has been witness to considerable change. These changes are considered in three parts; firstly transfer of public sector insurers to the Private Sector, which had the effect of increasing the size of the Private Sector market; secondly, a partial reversal of that transfer with the creation of Managed Funds and; thirdly, Private Sector corporate restructures Privatisation of State Insurers In the early to mid 1990 s most of the State insurers were privatised. This activity is summarised in Table 2.3. Table 2.3 Transfers from Public Sector to Private Sector Year Privatisation of the NSW CTP market 1989

14 Australian Competition and Consumer Commission 7 GIO (NSW) privatisation 1992 SIO (Vic) sale to GIO 1992 SGIO (WA) privatisation 1994 SGIC (SA) sale to SGIO 1995 TGIO (Tas) workers compensation sold to Fortis 1994 Housing Loan Insurance Corporation (HLIC) 1997 Suncorp Metway (Qld) privatised Creation of Managed Funds Following the privatisation of the various State insurers the Federal government and some State governments established captive insurers or Managed Funds. These Managed Funds were designed to directly underwrite risks or manage the insurance requirements of the public sector. This has had the effect of transferring a small volume of premium relating to government departments back to the public sector. Table 2.4 Managed Funds Year TMF (NSW) 1989 QIC (Qld) 1991 SAICorp (SA) 1994 VMIA (Vic) 1995 RiskCover (WA) 1997 Comcover (Federal) 1997 ACTIA (ACT) Insurance risks in Tasmania are managed by TASCORP Corporate Restructures The latter half of the 1990 s was dominated first by international merger and acquisition activity and more recently within the local market. Major changes are summarised in Table 2.5. Table 2.5 Major Private Sector Corporate Restructures Year Fortis purchase of AMEV 1990 Restructure of Wintethur s CIC with HIH 1993 Fortis purchase of selected TGIO holdings 1994 SGIO purchase of SGIC 1995 Royal Insurance and Sun Alliance merger 1996 General Accident (NZI) and Commercial Union merger (CGU) 1997 Allianz 100% ownership of MMI 1998 NRMA purchase of SGIO 1998 Public listing of HIH (exit of Wintethur) 1998 AMP purchase of GIO 1999 HIH purchase of FAI 1999 Merger of NRMA and RACV insurance operations 1999 Opening of Qld CTP market to other insurers 2000 CGU s local purchase of Fortis Australia 2001

15 Australian Competition and Consumer Commission 8 HIH liquidation 2001 Suncorp-Metway purchase of GIO Mergers and Acquisitions As for any industry, mergers and acquisitions (M&A) need to be justified in a financial sense otherwise there is no reason to pay a premium above the market in making an acquisition. Three reasons are generally cited that might lead to the acquisition of a general insurer for an amount in excess of current market value. These are the efficiency premium, synergy premium, and the acquisition premium. 3 The efficiency premium comes from the acquirer believing that the future profits of the company will be greater than the market currently thinks, thus greater value can be attributed to its share price. The synergy premium comes from the savings that will arise as a result of the savings and increased performance that eventuate as a result of the two businesses being integrated with each other. The acquisition premium comes from the increased value to the company as a result of the takeover International M&A The following outlines some of the main influences on the Australian market. Many of these are a direct result of international M&A activity. The purpose of the detailed descriptions is to give an indication of the level of recent activity. General Accident and Commercial Union General Accident (NZI in Australia) merged with Commercial Union in The combined entity was rebadged as CGU worldwide (including Australia). In Australia CGU, by premium volume, is currently the fourth largest insurer (refer Table 2.2). The year prior to the merger, NZI was ranked tenth and Commercial Union third. Premium revenue for CGU in 1997/98 was $1,408 million, compared with the combined premium revenue of $1,163 million for Commercial Union and NZI in 1996/97. While there was an increase in the premium revenue for CGU in 1997/98, an even greater increase in the premium revenue of Royal & SunAlliance resulted in CGU being relegated from third to the fourth largest insurer. Royal Insurance and Sun Alliance In 1992, Sun Alliance and Royal Insurance merged in Australia. The company was known as Sun Alliance and Royal Insurance. In 1996, the worldwide merger of Sun Alliance and Royal Insurance created Royal & SunAlliance. 3 Brigstock C, Johnston K and Watson B, (1999) What is a General Insurer Worth? Institute of Actuaries of Australia XIIth General Insurance Seminar.

16 Australian Competition and Consumer Commission 9 A far wider level of M&A activity has taken place internationally, initially with reinsurers and later with direct underwriters. However, these have related to companies with either one dominant operation in Australia or companies with little or no presence in the local market. As a result the landscape of the Australian insurance market was not significantly affected Domestic M&A The following discussion on HIH s takeover of FAI and Allianz s purchase of MMI is extracted from the paper titled What is a General Insurer Worth?. HIH Takeover of FAI The HIH takeover effectively started when HIH bought a 15 percent share of FAI from the Adler family in September HIH then made what was described at the time as a friendly takeover. The takeover offer provided two options for FAI shareholders: $2.25 cash plus one HIH share for every six FAI shares one HIH share for three FAI shares. When the bid was made HIH s share price was $2.29, effectively valuing FAI at $0.76 per share. This represented an increase of around 60 percent on the FAI share price of $0.47 one week before the announcement of the offer. The offer of $0.76 was also higher than the worth of the company according to analysts at the time who valued FAI at $0.56 to $0.60 per share. HIH justified the offer price by claiming: there were substantial synergy benefits available they had identified substantial savings that can be extracted in areas such as reinsurance and information technology the strong FAI band name and market position will be a valuable part of the HIH group. HIH eventually concluded the takeover in January 1999 with the share price of HIH remaining fairly stable during the time of the takeover. More recently HIH went into liquidation and parts of the HIH Group business were sold - Personal Lines to Allianz and Workers Compensation to NRMA. Allianz Purchase of MMI Allianz was the largest shareholder of MMI holding 68.5 percent. On 29 October 1998 it announced its intention to make a selective reduction of capital of MMI shares by cancelling MMI shares not owned by Allianz. To achieve this Allianz offered $2.20 a share, which contrasted to the then current market price of $1.40. Allianz also announced that following the purchase of MMI, it would make a further capital injection of $35 million into the company.

17 Australian Competition and Consumer Commission 10 This purchase differs from the HIH purchase of FAI in that an external assessment was sought to consider the offer. Grant Samuel was asked by MMI to provide an assessment of the offer. The report tabled by Grant Samuel valued MMI at between $1.55 and $2.27 per share, indicating that the offer price of $2.20 was close to the maximum in this range. The report tabled by Grant Samuel indicated that the price being offered was lower than the value of other insurance takeovers due to some of the problems that MMI had at the time. These included projected losses for the financial years 1998/99 and 1999/00, as well as doubts about the profitability of MMI s key product (workers compensation). Value was assessed by aggregating the fair market value of each of MMI s businesses. Fair value is defined as the maximum price that could be realised in an open market over a reasonable period of time, assuming that potential buyers have full information and ignoring special value attributable to one buyer only. CGU/Fortis Fortis recently withdrew from Australia following a trade sale of its local operations to CGU. The following is an extract from Cover Note 4 commenting on the deal. Consolidation drives Fortis out Fortis Aust CEO Vyn Tozer has blamed "ongoing consolidation" in the Aust market as a key reason Fortis sold to CGU this month. Tozer said while Fortis was profitable and held a strong position in its segment, "it has a small overall market share". CGU will buy Fortis for $330m, and expects to close the deal by Sept. Fortis brands VACC Insurance, Accident Insurance Mutual and AMEV Life are included. "Ongoing consolidation in the Aust industry has made scale a vital determinant in achieving market leadership, and this scale advantage continues to increase," Tozer said. CGU claims the Fortis purchase will push it to number one in the car warranty and financial institution distribution channels. CGU MD Ian Balfe said the acquisition, which is subject to regulatory approval, would consolidate CGU s position in the Australian market. S&P affirmed CGU s AA- insurer financial strength rating after the purchase was announced. "In the current environment, Fortis is one of the last opportunities to acquire a significant general insurance operation in Aust," Balfe said. Fortis was the 10thlargest private insurer in Aust, with $285m in gross written premium for CGU, formed in 1998 (CN 1140) after the merger of Commercial Union and NZI (CN 1118, 1119), is now ranked third. 4 Cover Note Issue 1262, 29 June 2001

18 Australian Competition and Consumer Commission Industry Growth Growth of a sector is a traditional measure used to examine trends within an industry. It is a poor measure of financial strength for individual insurance companies because it is relatively easy, in the short run, to increase premium volume by cutting rates without regard for profitability. However, at the industry level and over an extended period, it can provide a broad indictor as to the general health of the sector. In this review growth has been measured at three levels. These are: Gross written premium is the most common measure used to indicate the overall size of the market; Numbers of policies were also examined to indicate if the observed growth in premiums is driven by the volume of policies or by changes to the types or nature of covers; and Provision for outstanding claims liability was examined for differences in growth patterns to highlight other fundamental changes that may have taken place. Each measure is discussed following an examination of the extent of any change in the mix of business Changes in Business Industry wide measures can be misleading, as they do not take account of fundamental changes in the industry. An example of a change that would affect the three statistics described above is the potential privatisation of Workers Compensation in NSW. That would significantly increase premiums reported to APRA and increase the proportion of Private Sector business written in that class. Figure 2.1 illustrates the proportion of business written by Private Sector insurers in each class. It is designed to show if growth is uniform across classes or whether one particular class has contributed disproportionately to that growth. Inwards Reinsurance is a relatively new class and has been removed from the chart as its large rate of growth distorts the relativities and makes comparison over the years difficult for the other classes.

19 Australian Competition and Consumer Commission 12 Figure 2.1 Business Mix Gross Written Premium 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Financial Year Ended 30 June Other Other Accident Travel Consumer Credit Mortgage Employers' Liability Product and Public Liability Professional Indemnity Marine and Aviation Domestic Motor Vehicle Commercial Motor Vehicle CTP Motor Vehicle Houseowners/Householders Fire & Industrial Special Risks The main changes that can be elicited from Figure 2.1 are: The increase in CTP premium volume in 1996 was due to rate increases in NSW and in 1997 due to the inclusion of Suncorp-Metway, which had a significant proportion of the Queensland market when it was privatised; The transfer of Victoria s workers compensation business to Private Sector insurers in 1993/94 caused an increase in Employers Liability business. The reversal of that transfer occurred over 1997 and The transfers affected gross premium only as this business was 100 percent reinsured by the Victorian WorkCover Authority (VWA); Reducing proportion of Fire & ISR business throughout the 1990 s and the reversal of this trend in 2001; and The liquidation of the HIH Group resulted in a reduction in premium reported to APRA at 30 June The main classes affected are CTP (where FAI had a considerable share of the Queensland market), Professional Indemnity and Public & Product Liability Premiums The first measure of growth is gross written premium. For the year to 30 June 2001 gross Private Sector written premium in Australia by direct insurers totalled $15.7 billion (down from $17.2 billion due to the exit of the HIH Group).

20 Australian Competition and Consumer Commission 13 20,000 Figure 2.2- Industry Premiums Direct Insurers 15,000 10,000 5, Gross Written Premium (actual reported) APRA (ISC) Data Year ending 30 June Gross Written Premium (current values) From 1979 to 1989 gross written premiums increased by 9.5 percent p.a. 5. Gross written premiums continued to increase at 10.2 percent p.a. from 1992/93 to 1999/00. The 9 percent decrease from 2000 to 2001 is due to the exclusion of the HIH Group in APRA s returns. It is expected that reported premiums for the 30 June 2002 returns will jump significantly as they will include normal renewals that will be placed with the remaining insurers and additional premiums paid on existing covers, which had been placed in the HIH Group. The transfer of several State Government insurance offices to the Private Sector distorted growth rates in the 1990 s. The years between 1993 and 1995 are most affected by this (SIO-Vic $238m, SGIO-WA $174m, SGIC-SA $75m, TGIO- Tas $20m 6 ). Other significant transfers to the Private Sector were Suncorp in 1997, which added a further $645 million to the privately underwritten market and the HLIC in 1997 adding $66 million. After removing the one-off fillips to premium volume created by the privatisation of the State insurers, the average annual growth rate from 1992/93 to 1999/00 for gross written premium was 9 percent p.a.. After allowing for general price inflation during this period the real rate of premium increase (ie growth in excess of CPI increases) was 5 percent p.a. The real increase between 1996/97 to 1999/00 was only 2.6 percent p.a. after allowing for general price inflation. Although there were no transfers into the Private Sector there was a considerable amount of merger and takeover activity. This is discussed further in Section 2.3 above. 5 McCarthy & Trahair Lack of Industry Profitability and Other Stories p.24 6 These figures are estimates derived from annual reports at that time.

21 Australian Competition and Consumer Commission Economic Perspective Figure 2.3 demonstrates the change in gross Private Sector written premium as a percentage of GDP. The percentage increased during the mid 1990 s to 2.7 percent of GDP and has remained around that level since. The increase in the percentage of GDP between 1992/93 and 1994/95 and again in 1996/97 can be attributed to the transfer of State government offices to the Private Sector listed in Table 2.2. The low figure for 2001 reflects the exclusion of the HIH Group in APRA s returns. 2.8% Figure 2.3 Premiums as a Percentage of Gross Domestic Product 2.6% 2.4% 2.2% 2.0% APRA (ISC) Data Year Ending June 1 The reduction in 2000/01 is due to the exclusion of the HIH Group from the statistics. Actual premiums for the industry in 2000/01 will be considerably higher than that reported to APRA. After 1996/97, when the last State insurer transferred to the Private Sector, premium volume (in real terms) declined marginally from 2.7 percent to 2.6 percent of GDP. The increase between 1998/99 and 1999/2000 back to 2.7 percent indicates real premium increases occurred in that year Numbers of Policies The number of policies issued provides a measure of underlying growth in market penetration that can cause written premium to increase. Figure 2.3 illustrates the number of policies issued each year since 1992/93.

22 Australian Competition and Consumer Commission 15 Figure 2.4 Policies Issued 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5, The growth rate from 1992/93 to 1999/00 of 8.4 percent p.a. is similar to that observed for gross written premiums. This provides little evidence that there has been a fundamental change in policy terms and conditions and suggests that increases in revenue have largely been driven by growth/greater penetration Outstanding Claims Liability APRA (ISC) Data Year Ending 30 June Examination of movement in provisions for outstanding claims liabilities (refer Figure 2.5) reveals that these provisions doubled between 1992/93 and 1999/00. This represents an annual growth rate of 10.7 percent p.a., similar to that observed for gross written premiums and the number of policies issued. The reduction in aggregate provisions for the outstanding claims liability in 2000/01 is due to the exclusion of the HIH Group. The aggregate provision for the industry would be significantly higher if the HIH Group s provisions were included, however, the actual level of those provisions is still unclear. Figures provided to APRA for December 2000, which included the HIH Group, showed that provisions had just reached $15 billion. An additional $1 billion increase in provisions (the increase in HIH s provisions is reportedly higher than this) would increase the provisions to over $16 billion.

23 Australian Competition and Consumer Commission 16 Figure 2.5 Growth in Provisions $m 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2, APRA (ISC) Data Year Ending 30 June Figure 2.5 illustrates an obvious decrease in the rate of growth in provisions since 1997/98, which fell to a modest 3 percent increase in 1998/99 and 1999/00. Higher provisions need to be established for long-tail classes such as CTP compared to those required for short-tail classes such as Fire and ISR. The modest increase in provisions is surprising given that CTP premiums increased more than Fire and ISR in this period. Effectively, the lower growth in outstanding claims than premiums means hat provisions suffered a relative decrease. This occurred in a period when investment returns decreased and underwriting losses increased Average Premium Average premiums have been calculated as premiums in current values (30 June 2001) divided by the number of policies issued. This crude average premium rate should be treated with caution, as it takes no account of product mix or changes in policy terms and conditions. In particular, the large decrease from 1996/97 to 1997/98 is largely due to a revised definition of policies introduced by APRA. Figure 2.6 shows that the average premium rate decreased through to 1996/97 and has been relatively static since 1997/98. The average premium rate for the year to 30 June 2000 reveals a reversal of this trend and indicates that a general increase in premium rates has occurred. While numbers of policies have reduced due to the exclusion of the HIH Group, reported premiums reduced to a larger degree. The resultant reduction in average premium for 2000/01 calculated on the APRA statistics is consistent with the HIH Group writing, generally, larger policies. This also highlights the difficulty of comparing average premiums across years and between companies.

24 Australian Competition and Consumer Commission 17 Figure 2.6 Average Premiums $ APRA (ISC) Data Year ending 30 June Average Premium (per Policy) Average Premiums (current values per Policy) 2.5 Industry Performance Standard measures of the overall performance of the insurance industry include gross written premium (absolute growth), underwriting profit (premiums earned in the year less expenses and the incurred cost of claims), and investment revenue. Gross written premium was considered in Section 2.4 above. Underwriting profit (Section 2.5) and investment revenue (Section 2.6) are considered in more detail below. As stand alone measures, underwriting profit and investment revenue provide limited information as to the overall health of the insurance sector or company performance. Instead, it is important to consider indicators of financial performance such as: Loss Ratios to measure the adequacy of premiums (Section 2.5.2) Expense Ratios as a measure of operating efficiency (Section 2.5.3) Return of Equity as a measure of efficiency in use of capital (Section 2.6.3) Other performance indicators also provide valuable information (such as solvency), however, this report focuses on the listed measures to illustrate recent experience and trends that may impact the pricing decision Underwriting Profit Underwriting profit measures the excess of premium revenue over claims expense and underwriting expense. Typically, it is a loss, as it does not take into account the substantial investment earnings expected on the technical reserves (provisions for outstanding claims liability and unearned premiums).

25 Australian Competition and Consumer Commission 18 Figure 2.7 shows the underwriting result for the nine years ended 30 June Figure 2.7 Underwriting Profit (Loss) $m , ,200-1, APRA (ISC) Data Year ending 30 June 2000 There has been a noticeable decline in the underwriting result for Private Sector direct insurers since 1992/93. The last three years have seen the underwriting losses exceed $1 billion. The large increase in 1998/99 is due in part to the Sydney hailstorm of April This hailstorm has also had an effect upon the underwriting result for 1999/00 as payments continued and losses were fully realised throughout that period. The actual underwriting loss for 2000/01 is significantly higher than that illustrated as it excludes the recent losses in respect of the HIH Group. No definitive view is available on the extent of those losses. However, it is expected that the industry loss for 2000/01 is the worst recorded; far greater than that illustrated for 1998/ Loss Ratio Net loss ratios are calculated as the claims expense for the year divided by net earned premium. This figure represents that proportion of premiums allocated to meet the cost of claims. Target loss ratios vary according to the class of business but are generally expected to range from 50 percent to 80 percent. Loss ratios (refer Figure 2.8 which also shows combined ratio, described below in Section 2.5.4) have increased steadily up to 1998/99 and remained at that peak in 1999/00 before reducing to 79 percent in 2000/01. Loss ratios for the total industry were 83 percent for 1998/99 and 1999/00, a rise of 7 percent from the loss ratios of 76 percent in 1992/93 and 1993/94. A typical industry target loss ratio would be 75 percent or less.

26 Australian Competition and Consumer Commission 19 These recent loss ratios indicate that the industry can still be expected to achieve low returns although, in the absence of results for the HIH Group, remaining insurers appear to have a brighter outlook than the industry had 12 months ago. 120% 110% 100% 90% 80% 70% 60% Figure 2.8 Loss and Combined Ratios APRA (ISC) Data Year Ending 30 June Net Loss Ratio Combined Ratio Expense Ratio The other key component of profitability is measured by the expense ratio. This is calculated as operating costs for the year divided by net earned premium. Like loss ratios, expense ratios also differ by class of business. Expense ratios are expected to range from 20 percent to 30 percent across the industry. Expense ratios over the past nine years are illustrated in Figure % 31% 30% 29% 28% 27% 26% 25% Figure 2.9 Expense Ratio APRA (ISC) Data Year Ending 30 June

27 Australian Competition and Consumer Commission 20 Expense ratios peaked at 31 percent in 1993/94, and have been steadily declining since. The expense ratio in 2000/01 of 27 percent represents a slight increase over the lowest recorded of 26 percent in the previous year. The current levels reflect the increased premium volume for the privately underwritten sector resulting from the transfer of State insurers to the Private Sector and the subsequent rationalisation of the market Combined Ratio The absolute level of the combined ratio (loss ratio plus expense ratio) is an indicator of the overall profitability of each class of business. The combined ratio for the industry is shown in Figure 2.8 above. It is not uncommon for combined ratios to exceed 100 percent for some classes. These may still be profitable after investment income is taken into account. Recent increases in loss ratios have offset the decrease in expense ratios resulting in a slight increase in the combined ratio. The industry combined ratio for 2000/01 was 105 percent, compared to an average of 108 percent over the period illustrated. The recent reduction in the combined ration is driven by more favourable claims experience in the larger classes (Fire & ISR, Houseowners/Householders and CTP). Combined ratios in excess of 100 percent indicate that the industry relies on investment income on the technical reserves to generate profits Adequacy/Strength of Provisions The level of provisions established by insurers largely determines how industry profit emerges. However, sufficient detail is not available in the published APRA statistics to properly assess the adequacy of these provisions. In the 12 months from 1998/99 to 1999/00, provisions for accident years up to 1998/99 for specified liability classes had increased by 25 percent or $840 million. This is considerably higher than would be expected on the basis of one year s movement and indicates recognition of a need for significantly higher reserves. However, recognition of this past under-reserving does not guarantee that current reserves are necessarily adequate. Therefore, there is still potential for further increases in provisions and hence reported losses. This is clearly demonstrated by the liquidation of the HIH Group, which is expected to result in significant upward revisions in the provisions in Under estimation of reserves can lead to the under estimation of projected costs and hence under charging for assumed risks. This is particularly the case for long-tail classes such as Professional Indemnity and Public & Product Liability. 2.6 Financial Performance Financial performance is measured by the return on equity (shareholders funds). This consists of underwriting profit and investment revenue.

28 Australian Competition and Consumer Commission Underwriting Profit There has been a noticeable decline in the underwriting result for Private Sector direct insurers since 1992/93 (refer Section 2.5.1). Losses have exceeded $1,000 million dollars each year for the years ended 30 June 1999, 30 June 2000 and 30 June The highest recorded underwriting loss of $1,244 million was recorded in the year ended 30 June 1999, however, this may be exceeded by 30 June 2001 when the full impact of the liquidation of the HIH Group is included Investment Revenue $m Investment revenue generated by insurers is largely dependant on the performance of the stock market both in Australia and overseas. Investment income for the industry peaked in 1997 at $2,746 million, which was primarily due to the record return on the stock market that year. Figure 2.10 illustrates the investment revenue earned by Private Sector insurers over the last nine years. 3,000 2,500 2,000 1,500 1, Figure 2.10 Investment Returns APRA (ISC) Data year Ending 30 June Investment revenue forms a critical component of insurance profit and the overall return on equity (refer Section below). In order to determine the profitability of each class and the contribution to overall industry profitability a notional allocation of investment income has been made to each class. The basis of allocating investment income has been described in Appendix B.